Free Cash Flow

Fin 325, 11/23/2020                                                 QUIZ 4—in class version

30 pts. total

 

You will get this quiz paper back.  Please insert your note page(s) behind this page when done.  You MUST enter all your responses in writing (below) AND electronically in your iClicker.  (Remember to scroll forward to the next question, after entering each response.)

 

True/False (2 points for each question, 6 questions, 12 points total)

Indicate whether the sentence or statement is true (write “T” below) or false (“F”).  Choose “A” on your iClicker for True responses and “B” for False responses.

 

1. Suppose you are calculating Free Cash Flow.  To account for depreciation, one should subtract depreciation expense from operating income.

 

2. We briefly reviewed the case of Core Logic Inc. (CLGX).  CLGX stock was being purchased by an activist investor group that wanted changes made to CLGX’s board of directors.  We briefly reviewed in class the following table provided by ISS, a proxy advisory firm.

The point of this table was that CLGX’s valuation comparables were significantly less than peer firm valuation comparables.  This implies the current CLGX management is underperforming.

 

3. ing a call option, investing the present value of the exercise price in T-bills, and short-selling the underlying share generates the same payoff as selling a put option.  (Hint: use put-call parity.)

 

4. According to the assigned article “ARAMCO Maintains $18.75b Dividend,” the Saudi Arabia Oil Company is maintaining the dividend promised in last year’s IPO despite the dividend being larger than its free cash flow and also despite a sharp drop in profits.

 

5. Jillian owns a large number of American options (that trade on the CBOE) which give her the right to purchase shares of WAN stock at a price of $20 a share over the next month. Currently, WAN stock is selling for $24.50. Jillian would like to profit on her holding of the WAN options right now because she is concerned that WAN’s stock price may fall in the next month.  Jillian’s best course of action is to exercise her options now and earn a payoff of $4.50 per option.

 

6. To replicate a call option, an investor would need to delta shares of the underlying stock and then engage in risk-free lending by purchasing Treasury bills.

 

Multiple Choice (3 points for each question, 6 questions, 18 points total)

Identify the letter of the choice that best completes the statement or answers the question.  For numerical problems, choose the response closest to the number you calculate.

 

7. Which of the following scenarios fails to describe a possible real option embedded in a project analysis?

 

a.	A new product line started with future follow-on investments available	d.	A five-year lease that allows the lessee to sublet the leased property.
b.	A truck fleet outfitted with engines capable of running on five various types of fuel	e.	A patent developed on a new process of slicing bread
c.	The articles of incorporation amended to allow for stock splits and reverse stock splits

 

 

8. Tech Com announces a major expansion into Internet services. This announcement causes the price of Tech Com stock to increase, but also causes an increase in the volatility of the stock price. Which of the following correctly identifies the impact of these changes on the price of Tech Com call options?

 

a.	The greater uncertainty will cause the price of the call option to increase. The higher price of the stock will cause the price of the call option to decrease.	d.	Both changes cause the price of the call option to decrease.
b.	The greater uncertainty will cause the price of the call option to decrease. The higher price of the stock will cause the price of the call option to increase.	e.	It is not possible to tell the impact on the price of the call option, given the information given.
c.	Both changes cause the price of the call option to increase.

 

 

 

 

9. Which of the following will increase the value of a put option?

a.	Stock price increases.
b.	The exercise price increases.
c.	The stock price volatility decreases.
d.	The time to maturity decreases.
e.	None of the other choices results in an increase in the value of a put option.

 

10. Calculate the value of the May 21, 2021 call option on DKNG with a strike price of $45.00, using the Black-Scholes formula.

 

You can assume that the time to maturity of this option is exactly 6 months.  The volatility is 0.7399, i.e. 73.99% per year.  The risk-free rate, on 6-mo. T-bills, is 0.102% per year.  (The z-table is incorporated into the end of this problem, for your convenience.)

a.	$9.50	d.	$11.00
b.	$10.00	e.	$11.50
c.	$10.50

 

 

 

 

11. You are a consultant who was hired to evaluate a new product line for Markum Enterprises. The upfront investment required to launch the product line is $10 million. The product will generate free cash flow of $750,000 the first year, and this free cash flow is expected to grow at a rate of 4% per year. Markum has an equity cost of capital of 11.3%, a debt cost of capital of 5%, and a tax rate of 35%. Markum maintains a debt-equity ratio of 0.40.

What is the NPV of the new product line (including any tax shields from leverage)?

 

a.	$4.50M	d.	$5.25M
b.	$4.75M	e.	$5.50M
c.	$5.00M

 

 

12. Consider the attached financial statements from the Beacon simulation for team Leo (from a different class than yours) for Year 6.

 

What is the Free Cash Flow in Year 6 for team Leo?

 

 

 

a.	$8.50M	d.	$9.25M
b.	$8.75M	e.	$9.50M
c.	$9.0M

 

 

 

Finance 325, Fall 20, Quiz 4

Answer Section

 

TRUE/FALSE

 

1. ANS:   F

Need to add depreciation expense.

 

iClicker question.

 

PTS:    1

 

2. ANS:   T                      PTS:    1

 

3. ANS:   F

ing a put option.

 

C_EX + PV(EX) = P_EX + S

 

C_EX + PV(EX) -S = P_EX

 

MFL 20A #4

 

PTS:    1

 

4. ANS:   T                      PTS:    1

 

5. ANS:   F

She should trade the options to someone else who will value the time value remaining on the option.  She will thus earn more money from trading the options as opposed to selling the options.

 

PTS:    1

 

6. ANS:   F

To replicate a CALL option, an investor would need to delta shares of the underlying stock and then engage in risk-free borrowing.

 

To replicate a PUT option, an investor would need to SELL delta shares of the underlying stock and then engage in risk-free lending.

 

PTS:    1

 

MULTIPLE CHOICE

 

7. ANS:   C

MFL 22A, #4

 

PTS:    1

 

8. ANS:   C

MFL 22A, #9

 

PTS:    1

 

9. ANS:   B

iClicker question

 

PTS:    1

 

10. ANS:   D

 

The calculations come close to mirroring the values in the table.  In fact, the “IV” column, from the chart that was given, is calculated based on inferring what level of volatility is consistent with the call option price.  (“IV” stands for “implied volatility”.)

 

For reference, here is the full quotation:

 

 

PTS:    1

 

11. ANS:   C

WACC = (1 / 1.4)(11.3%) + (.4 / 1.4)(5%)(1 – .35) = 9%

V^L = 0.75 / (9% – 4%) = $15 million

NPV = –10 + 15 = $5 million

 

PTS:    1

 

12. ANS:   C

note that t_c (from income statement) is 22%

 

1. a) FCF = EBIT*(1-t_c) – Capex + Depreciation – Change in NWC

 

FCF = 9.17*(1-0.22) – 2 + 3.27 – (-0.58) = 9.0

 

Note that you found the last 3 numbers from the Statement of Cash Flows (SOCF).  Also note that the “Inventory Reduction” listed on the SOCF ends up increasing FCF.

 

PTS:    1